For financial institutions, capital is a buffer against insolvency. It is available to absorb unforeseen losses so the firm can remain in business. The more capital a firm has relative to the risks it takes, the more confident stakeholders are that it will meet its obligations to them. Of course, capital alone is no guarantee of solvency. A well capitalized firm can fail due to a lack of liquidity.
How do we tell if a financial institution has sufficient capital? This is the question of capital adequacy. Traditionally, it was addressed for depository institutions with the capital ratio, which is defined in terms of the book value of capital and assets as
For depository institutions, assets were loans, so the capital ratio would give an indication of capital relative to credit risk. Capital ratios might be in the range of 4% to 10%, depending on the size of the firm, its industry and the definition of capital used. Capital is generally defined to include common stock, non-cumulative preferred stock and retained earnings, but it may also include lesser-quality items such as general loan loss reserves, long-term subordinated debt and cumulative and/or redeemable preferred stock.
Deregulation during the 1970s and 1980s exposed depository institutions to increased competition. To maintain profitability, many leant to lesser credits. In this environment, capital became more important as a buffer against losses. The more risk a firm took, the more capital it needed. As a proxy for credit risk, book value of assets does not distinguish between good and bad credits, so regulators and practitioners modifying the traditional capital ratio or abandoning it completely.
Modifications took the form of the risk-adjusted capital ratio:
where risk-adjusted assets are calculated by multiplying the value of each asset by a risk weighting and summing the results. This was the approach employed by the 1988 Basel Accord. Somewhat crudely, it applied the following weights:
- 0% for G-10 government debt,
- 20% for G-10 bank debt,
- 100% for corporate debt and the debt of non-G-10 governments.
Another approach to assessing capital adequacy is required capital calculations based on systems of capital charges. These evolved out of the Bankers Trust RAROC methodology of the 1980s, US insurance regulators’ risk-based capital requirements developed during the 1990s, and refinements of the Basel Accords during the 1990s. These methodologies easily incorporate risks beyond credit risk, an important consideration as barriers fell between certain types of financial institutions, and depository institutions faced new market risks and operational risks.
Generally, a firm’s risks are identified and an amount of capital is specified to support each. The amounts are called capital charges. They are summed across all the identified risks, perhaps with adjustments to reflect hedging or diversification effects. If the sum capital charge exceeds the firm’s capital, the firm needs either to raise more capital or reduce some of its risk.
Capital charges are assigned in a manner appropriate for each risk. These can be crude formulas or sophisticated analytic techniques, such as value-at-risk (VaR). For example, in certain circumstances, the Basel Accords assigned capital charges for market risk based on a calculation of 10-day 99% VaR for a bank’s trading book.
More problematic is how to adjust capital charges for hedging or diversification across risk types. How, for example, does one calculate the correlation between a bank’s market risk and its credit risk? Solutions are inevitably crude. One is to simply sum capital charges across risk types, recognizing no diversification benefits. Another is to square the various risk’s capital charges, sum them, and then take the square root. This approach treats the risks are uncorrelated, reducing the sum capital charge to recognize the diversification effect.
Over the years, regulators have formalized risk-based capital requirements in various regulations. These have defined rules for calculating a firm’s capital and suitable capital charges. These analyses are called regulatory capital calculations. They have been employed in the 1996 amendment to the Basel Accord, Basel II, Basel III, the National Association of Insurance Commissioners risk-based capital requirements, and Europe’s Solvency II directive for insurers.
Similar proprietary systems have been developed by financial institutions to support their own internal analyses and planning. To distinguish these from regulatory capital calculations, such analytics are called economic capital calculations.